Monetary policy: US - Fed

Federal Reserve monetary policy instruments and operating targets

Operating procedure

Until January 2003 the Fed set the discount rate consistently somewhat below the desired federal funds rate, relying on non-pecuniary influences to restrain banks from borrowing cheap reserves through the discount window. In January 2003 the Fed changed the operation of the discount rate by setting it at a penalty rate above the desired federal funds rate target (100bp primary credit rate, and 150bp secondary credit rate).

The FRBNY usually intervenes in the market 1 time each day, early in the morning. It does so by dealing with selected large commercial banks, i.e. primary dealers in government securities.

Given the averaging and carry-over features of the system of reserve requirements, actual behavior of current reserve demand is a complex function of commercial banks expectations with respect to future reserve demand and supply movements.

From October 2008 the Fed pays interest on bank reserves, differentiating between required and excess reserve balances and changing the interest rate determination somewhat over time. Since then the amount of excess reserve balances held by banks has exploded to unprecedented levels.

Operating targets

Exactly which operating target) the Fed employs in its dealings with the market has changed through time. Currently the Fed uses an explicit target or, more precisely, expected or average level for the federal funds rate. Because the Fed intervenes in the money market daily it has very close (though not perfect) control over developments in the federal funds market. Because the Fed intervenes only 1 time each day the actual intra-day and end-of-day federal funds rate will fluctuate due to daily unexpected fluctuations in reserve demand (Rudebusch, 1995).

Federal Reserve monetary policy strategy

Beginning in 1970, the FOMC selected weekly tracking paths for M1 and indicated its preferred behavior for M2 (Meulendyke 1999). In the years before 1975, the FOMC established ranges for some of the monetary aggregates, specified for 6-month time horizons. In April 1975, in response to a congressional resolution (House Concurrent Resolution 133, passed March 24, 1975), the Fed began to announce publicly targets for long-run (= annual) money growth. Short-run ranges (= 2-months) were also used. The Fed Chairman was required to consult with Committees of the Congress on a quarterly basis with respect to the objectives and plans over the next twelve months (i.e. the April 1975 FOMC ranges applied to the year ending 1976Q1, the July 1975 ranges applied to the year ending 1976Q2, etc.). From 1979 the FOMC published money growth ranges in its semi-annual Monetary Policy Report to Congress, persuant to the Full Employment and Balanced Growth Act of 1978. The normal policy cycle required that provisional target ranges were established for next year (4th quarter-4th quarter) at the June FOMC meetings, to be formally decided on at the next February FOMC meeting (and reported in the February Monetary Policy Report) and possibly revised midyear at the June FOMC meeting (and reported in the July Monetary Policy Report). In practice, the Fed did not consider meeting the money growth targets to be of high priority, placing greater weight on reducing unemployment, while maintaining a relatively smooth path for interest rates. Devices employed by the Fed to avoid being overly constrained by money growth targets included the setting of targets for more than one aggregate, which usually allowed it to claim that it was hitting at least some target; and the frequent resort to “base drift”; that is, the ignoring of past deviations of money growth from target when setting new targets (Bernanke and Mishkin 1992). In February 1987, the Fed announced that it would no longer set M1 targets, and in July 1993 Chairman Greenspan testified before Congress that the Fed would "downgrade" the use of M2 as a reliable indicator. At its June 2000 meeting the FOMC did not establish ranges for growth of money and debt in 2000 and 2001. The legal requirement to establish and to announce such ranges had expired, and the Fed concluded that, owing to uncertainties about the behavior of the velocities of debt and money, the ranges had not provided useful benchmarks for the conduct of monetary policy (Fed Bulletin, Monetary Policy Report July 2000).

In practice, setting aside the formal legal requirement to publish monetary growth targets, since the October 1979 announcement by Chairman Volcker on the revised implementation of monetary policy, the Fed has operated a pragmatic inflation targeting regime. The Full Employment and Balanced Growth Act 1978 amendment of Employment Act 1946 actually required the U.S. Administration to set annual numerical goals for key indicators over a 5-year horizon, leading toward a group of interim goals set forth by Congress (Federal Outlays 20%GNP, unemployment 4% and inflation 3% in 1983). The Humphrey-Hawkins Act for the first time explicitly established the goal of reasonable price stability as a high priority objective of national policy. After the initial period of disinflation in the early 1980s, resulting in a period of high policy real interest rates, the good descriptive performance of the so-called Taylor rule, and comparable direct policy rule estimates, shows that the Fed under Chairman Greenspan in practice operated and continues to operate with an inflation target of around to 2% (probably a little higher in the late-1980s and early-1990s).

On 25 January 2012 the FOMC finally made explicit what most careful observers had already inferred from previous individual speeches by FOMC members and actual policy actions: price stability and a numerical inflation goal has become the primary objective of Fed policy. "The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate" (i.e. promoting maximum employment, stable prices, and moderate long-term interest rates). In December 2012 the FOMC qualified its price stability objective, returning some emphasis to the second pillar of its dual mandate. The 'close to zero' interest rate policy was conditioned on unemployment being above 6.5% and/or inflation forecasts not exceeding 2.5%.

Federal Reserve: Legislation, decision-making, transparency

The Federal Reserve Act of 1913 set up the Federal Reserve System and granted it the legal authority to issue Federal Reserve bank notes in order “to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.” Disappointing experience with the conduct of monetary policy, led to the Banking Act of 1933 which amended the Federal Reserve Act and created the Federal Open Market Committee (FOMC). The FOMC has the power to direct all open-market operations of the district Federal Reserve Banks. The goals of economic and monetary policy where refined in several Acts. The Employment Act of 1946 required the federal government to pursue "maximum employment, production, and purchasing power". The 1977 Federal Reserve Reform Act required the Board and the FOMC "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." The 1978 Full Employment and Balanced Growth Act (aka Humphrey-Hawkins) mandates the Board to design monetary policy to maintain long-run growth, minimize inflation, and promote price stability. The FEBGA also provided some explicit inflation targets for economic policy.

Authority for monetary policy decisions is divided between the Board of Governors of the Federal Reserve (Board) and the Federal Open Market Committee (FOMC). The Board decides on changes in discount rates after recommendations submitted by one or more of the regional Federal Reserve Banks. The Board also decides on reserve requirements and other formal regulations. Board members are also members of the FOMC. The FOMC decides on open market operations, including the desired levels of central bank money (alternatively referred to as federal funds, bank reserves, outside money, base money) or the desired federal funds market rate. The Federal Reserve Bank of New York (FRBNY) actually executes open market operations, using outright sales/purchases of government securities or, more frequently, repurchase agreements.

The FOMC has scheduled 'meetings' approximately once a month, usually on Tuesdays (the frequency has fallen from 12 times to 8 times per year). Additional emergency meetings are possible in the form of teleconference calls. Before 1994 the FOMC often changed its policy stance between meetings, but since 1994 only rarely (Thornton and Wheelock, 2000). From February 1994 monetary policy decisions are published through a press release immediately following the meetings. The FOMC domestic policy directives with operational details for the FRBNY are only published with a time lag. From August 1997 the FOMC specifies an explicit target for the federal funds rate in its directive. Previously, the directive had been expressed in terms of "the degree of pressure on reserve positions" and was translated into a federal funds rate "expected to be consistent with desired reserve constraint". Despite the operational targets being published only with a lag before 1994, market participants were usually very quick in recognizing changes in the operational target for the federal funds rate because of the Fed's close control over the federal funds market. These changes were then reported in the financial press, for example the Wall Street Journal (see for example, Cook and Hahn, 1989).

Starting with the Federal Reserve Reform Act of 1977 the Fed Chairman is initially requested and later required to appear before Congress at semi-annual hearings to report on the conduct of monetary policy.

Before 1994 only the changes in discount rates were announced publicly. Historically, the precise meaning of discount rate changes in terms of monetary policy actions has not been unambiguous. Sometimes a change in the discount rate was used to publicly signal a change in policy. All else being equal, lowering the discount rate resulted in a lower federal funds rate. However, sometimes the discount rate was changed merely for technical reasons. For example, more restrictive open market operations raised the federal funds rate and increased the incentives of commercial banks to use discount window borrowing. Because the Fed discouraged discount window borrowing for any other purpose than short-term liquidity problems, it increased the discount rate to reduce the incentives for discount window borrowing. The discount rate changes frequently lagged the actual change in monetary policy stance.

HISTORICAL DATA, TABLES, SUPPLEMENTARY INFORMATION

Sources: Federal Reserve Bulletin, FRBNY http://www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html, http://www.federalreserve.gov/fomc/fundsrate.htm

FOMC press releases http://www.federalreserve.gov/fomc/, Federal Reserve Board press releases http://www.federalreserve.gov/newsevents.htm, http://www.federalreserve.gov/monetarypolicy/fomc.htm

The Federal Reserve Bank discount window and payment system risk website: http://www.frbdiscountwindow.org/

Table Federal Reserve Chairman

Fed Unconventional Monetary Policy Actions/Programmes

Operation Twist (1961) - Operation Nudge

Announced 2 February 1961. Effective 1961-1962, officially ended 1965. Federal Reserve from February 1961 to purchase longer-term U.S. Treasuries and lower long-term interest rates while maintaining the level of the federal funds rate. U.S. Treasury at the same time to issue primarily short-term securities. Total purchase by Fed of long-term Treasuries estimated $ 8.8 bln, while at the same time reducing short-term Treasuries by $ 7.4 bln.

QE1 - Asset Purchase Program

Announced 25 November 2008. Ended March 2010. From December 2008 Fed to purchase up to $ 600 bln in agency MBS and agency debt. On 18 March 2009 expanded by additional $ 850 bln of agency MBS and debt and $ 300 bln U.S. Treasuries.

QE2

Announced 3 November 2010. From November 2010-June 2011 Fed to purchase additional $ 600 bln in longer-term US Treasuries.

Operation Twist (2011) - Maturity Extension Program

Announced 21 September 2011. Purchasing Treasury securities with remaining maturities of 6 -30 years and selling maturities of 3 years or less. Designed to reduce long-term interest rates, without affecting liquidity conditions, and maintaining Federal Funds Rate at 0-0.25 percent target range. Initial program September 2011-June 2012 of $ 400 bln, extended in June 2012 until end 2012 for approx. additional $ 267 bln.

QE3

Announced 13 September 2012. Open-ended program to purchase agency MBS at a rate of $ 40 bln per month. In December 2012 expanded (sometimes referred to as QE4) by purchases of Treasury securities at a rate of $ 45 bln per month; total $ 85 bln per month. On 18 December 2013 the FOMC decided to reduce its asset purchases by $ 10 bln per month ('tapering') starting in January 2014.

Board of Governors of the Federal Reserve System

United States monetary policy. Webpage FRB Minneapolis.

U.S. monetary policy: An introduction. Webpage FRB San Francisco.

Central bank

• How is the Federal Reserve structured? Webpage FRB San Francisco.
• Federal Open Market Committee. Federal Reserve Board.
• United States monetary policy: Federal Open Market Committee (FOMC). Webpage FRB Minneapolis with relevant links.

Monetary policy tactics

• Monetary policy tools. Federal Reserve Board
• Madigan, B.F. and W.R. Nelson, "Proposed revision to the Federal Reserve's discount window lending programs," Federal Reserve Bulletin, July 2002: 313-19.
• Meulendyke, A., "U.S. Monetary Policy and Financial Markets", FRB New York, 1998.
• Akhtar, M.A., "Understanding Open Market Operations", FRB New York, 1997.
• United States monetary policy: Instruments of monetary policy. Webpage of the FRB Minneapolis with relevant links.
• U.S. Monetary Policy: An Introduction Webpage FRB San Francisco.

Monetary policy strategy

• Monetary Policy Report to the Congress. Federal Reserve Board.
• United States monetary policy: Monetary policy objectives. Webpage of the FRB Minneapolis with relevant links.
• U.S. Monetary Policy: An Introduction Webpage FRB San Francisco.